This paper argues that private-label securitization without regulation is unsustainable. Without regulation, securitization allowed mortgage industry actors to gain fees and to put off risks. During the housing boom, the ability to pass off risk allowed lenders and securitizers to compete for market share by lowering their lending standards, which activated more borrowing. Lenders who did not join in the easing of lending standards were crowded out of the market.
In theory, market controls in the form of risk pricing could have constrained heightened mortgage risk without additional regulation. But in reality, as the mortgages underlying securities became more exposed to growing default risk, investors did not receive higher rates of return. Artificially low risk premia caused the asset price of houses to go up, leading to an asset bubble and creating a breeding ground for market fraud. The consequences of lax lending were covered up and there was no immediate failure to discipline the markets.
The market might have corrected this problem if investors had been able to express their negative views by short selling mortgage-backed securities, thereby allowing fundamental market value to be achieved. However, the one instrument that could have been used to short sell mortgage-backed securities—the credit default swap—was also infected with underpricing due to lack of minimum capital requirements and regulation to facilitate transparent pricing. As a result, there was no opportunity for short selling in the private-label securitization market. The paper ends with a proposal for countercyclical regulation to prevent a race to the bottom during the top of the business cycle.
Affordable Housing Architecture Asia Borrowing Constraints Canada China Colombia Commercial Brokerage covid-19 CRE Credit Risk Transfers Debt Market Demographics Development e-Commerce Equity Market Ethnic Factors Europe Foreclosures Global Global Financial Crisis hospitality Housing & Residential Housing Supply India inflation Investing land use regulation Macroeconomics Microeconomics Mixed-Use Mobility Mortgage Rates Mortgages Multi-family Non-Traditional Mortgages office sector Political Risk Real Estate Investment Trusts Recession Rental Retail South America Sub-Prime Mortgages Sustainability United States Urban Urbanization work from home